8/11/2003 @ 12:00AM

Pay Now, Learn Later

You can protect yourself against college tuition hikes. But the scheme backfires if your kid goes to the state university

By now you probably know that
earnings
of Section 529 college savings accounts are free of federal tax if used for higher education. But taxes are only part of the problem. What if your investments tank? Just ask Laurence and Margo Williams of Alexandria, Va. In 2000 they put $45,000 into the Virginia Education Savings Trust to
open accounts
for daughters Lea, now 5, and Anne, now 3. Since then their investment has shrunk 5% while the average private college tuition has climbed 18% to $18,300.

So there’s sure to be much interest in September when more than 200 private colleges begin offering the Independent 529 Plan–a complicated new scheme that lets you prepay a child’s private college tuition at a discount to today’s rates.

The Independent plan isn’t for everybody. But it should appeal to some affluent parents and grandparents who are gun-shy of stocks and strongly favor private over public colleges. “I think grandparents are going to love it, because they tend to take a conservative approach,” says Raymond Loewe, author of New Strategies for College Funding. “People who have been burned in the market–and a lot of them have–will like this approach.”

A little history: Starting in the mid-1980s a handful of states began offering prepaid plans for their own schools. These plans had little appeal for parents aiming to send their kids to the Ivy League–or at least give them a wide choice of colleges. In 1996 Congress added Section 529 to the tax code, allowing states to offer the more flexible and popular college savings plans that can be used at any school.

Money in 529 savings plans grows tax deferred and can be withdrawn federally tax free if used for certain educational expenses. Those include undergraduate and graduate tuition, supplies and room and board (on campus or off) at any public or private college or university. Plans typically allow total contributions of more than $200,000, and there are no annoying income restrictions for contributors, as there are with so many other savings breaks.

Moreover, 529s have a gift-tax advantage as well: A couple can contribute up to $110,000 at once to each child or grandchild’s account without owing gift taxes. The contribution is treated as five years’ worth of annual tax-exempt gifts of $11,000 per year, per parent. After five years all the money is out of a donor’s estate, yet he or she can take it back for any reason. (Such noncollege withdrawals are taxed at the ordinary income rate, plus a 10% penalty on earnings.)

You can’t manage the investments in a 529 yourself. But you can choose from dozens of plans offering
mutual funds
from such firms as Vanguard, Fidelity and Smith Barney. Naturally, your return depends on the performance of the funds and the fees you’re charged, which in broker-sold 529s can be steep. If you’re dissatisfied with returns, there’s an out: Once a year you can pick different options in your plan or roll your college kitty into a different state’s plan, without taking a federal tax hit. (Whether the state will let you switch without a
redemption
fee or tax is another matter.)

Choosing a plan is already plenty complicated. But in 2001 Congress authorized yet another type of 529–a prepaid plan sponsored by the private colleges themselves. The first and likely only one of these is the Independent, offered through the not-for-profit Tuition Plan Consortium. Money put into this 529 buys tuition certificates that can be used at any participating college. Schools that have already signed on include Princeton, Amherst, Oberlin, Emory, Smith, Notre Dame and the University of Chicago. Harvard is one big-name school that is definitely not expected to participate now. (A complete list should be posted at www.independent529plan.org in September.)

Just how much future tuition a deposit today buys depends on which college your child attends, the number of years until your child enrolls and the discount rate the college offers. Here it gets complicated. Colleges must offer a minimum 0.5% annual discount. (Alas, the discount compounds, making it a bit smaller. Fifteen years at 1% adds up to a 14% discount.) If a college’s current tuition is $25,000 and it offers a typical 1% discount rate, you’ll need to plunk down $21,500 to lock in a year of tuition 15 years from now. (Click here to access the discounted tuition calculator.) If the kid ends up going to a participating school that either is cheaper or offers a better discount, the same investment will buy a bit more than a year of tuition.

The discounts are significant, since most state prepaid plans now charge a premium to current tuition for future years. Compared with them, the Independent looks like a good deal. Schools are free to raise or lower both their tuition and discount rates each year, but only for new deposits, not past ones. If new schools join the plan, you get retroactive benefits–your previous contributions lock in whatever tuition the new school charged when you invested, at a discount equal to the median discount schools in the plan offered that year.

School Choice Douglas Brown, chief executive of the Tuition Plan Consortium, predicts more than 300 private colleges will eventually join the plan. “The number of colleges is key,” says CPA Joseph Hurley, who runs www.savingforcollege.com, which offers comprehensive information on 529s.

Here’s why: If your child ends up at a state school or a private school outside the plan, or not going to school at all, you can get your money back–but with a paltry maximum annual return of 2%, or a negative return of up to 2% if the plan has lost money. (This return is tax free if the cash is used for college or rolled into another 529.) If you are funding multiple kids’ educations and one opts for a nonplan school, you can roll the tuition credits over to another child’s prepaid account, without any penalty.

But no matter how long the list of participating private schools grows, if you live in a state with a top public university, consider whether your child might go there before investing big bucks in the Independent. In-state tuition at the University of Michigan averages $8,000; at the University of Virginia it’s just $6,000; and at the University of North Carolina at Chapel Hill it’s a bargain-basement $4,000. Two-thirds of students at four-year colleges attend state schools, and a growing number of public colleges offer fine honors programs for top students. Moreover, the Independent plan is of no use if your kids attend state schools as undergraduates and then private graduate schools; as of now the Independent covers only undergraduate tuition, whereas 529 savings plans can be used for graduate school, too.

Rate of Return
Assuming your child is admitted to and attends a participating college, will you get a competitive return on your money from the Independent plan? That depends on how
market returns
compare with tuition increases and how you’d otherwise invest.

Since 1975, which includes a period of high
inflation
, private college tuition has risen an average of 8% a year. (Princeton’s smaller climb is illustrated below.) Add in the typical 1% discount expected to be offered by colleges in the plan and the annual return on the Independent would have averaged 9.1%. During the same period the S&P 500 returned an average of 13.5% and
long-term
government bonds
9.9%, according to Ibbotson Associates.

On the other hand, stocks are trading at about twice their long-term price/earnings average, so you might expect lower returns over the next decade. And the three-year bond rally may well have run its course. The Independent plan also charges no initial or annual fees to eat into your returns. And, assuming your kids do go to private school, the Independent is simply less risky, especially if you need your money in a particular year; while stocks go up and down, tuition always goes up.

There are low-risk options in some 529 savings plans, too, but they offer mediocre returns. Most state plans run by TIAA-CREF offer guaranteed options currently paying 3% to 4%. Montana and Arizona offer
certificates of deposit
paying 2% less than the increase in private college tuition, with a guaranteed minimum of 2% a year.

Of course, the fact that college officials are willing to offer a discount on future tuition shows they believe they can earn more on investments than the increase in tuition. If you’d rather try to earn higher returns yourself, consider 529 plans in the five states with Vanguard funds or the 13 with TIAA-CREF funds.

State Tax Breaks If you opt for the Independent 529, you’ll miss out on the deductions that half the states offer residents contributing to their own plans. In some low-tax states this doesn’t amount to much. But a New York City couple can deduct up to $10,000 a year in contributions, saving maybe $800 (net of the value of the federal deduction for state and city tax). There’s also the danger that a state will try to tax the return from the Independent 529; Pennsylvania, Tennessee and Illinois, for example, now punish residents who go out of state by taxing earnings from out-of-state savings plans, says Hurley.

Consider contributing to both the Independent 529 and your state’s savings plan, putting enough in the latter to grab the maximum state break. This makes sense anyway, because the Independent covers only undergraduate tuition, whereas savings plans can be used to pay for supplies and room and board and graduate school, too.

Financial Aid Money you save in any 529 plan might lower the amount of aid the federal government and private colleges are willing to provide when your child reaches college. But the Independent plan will likely have a bigger impact than a 529 savings plan. Families with incomes above $125,000–unless they have two or more children in pricey colleges at the same time–are unlikely to get need-based aid anyway.

Tax-Code Roulette If Congress fails to extend tax-free withdrawals from 529s, earnings taken out after 2010 will be taxed at the child’s ordinary income rates, as will any increase in the value of tuition you’ve bought with the Independent. How likely is that? Parents, states, colleges and the financial service industry would all scream if 529s’ benefits were threatened.

Alternative savings plans are no better. Coverdell Education Savings Accounts (previously called Education IRAs) were made far more attractive by the 2001 tax act, but those enhancements also expire come 2011. A parent or grandparent can set up a Coverdell directly with a firm like Vanguard or T. Rowe Price and then contribute up to $2,000 annually per child. The money grows tax deferred and can be withdrawn tax free if used for “qualified educational expenses,” which include not just college but also private elementary and secondary tuition, tutoring and even a computer. To contribute you must have an adjusted gross income below $110,000 if single or $220,000 if filing jointly. If your income is too high, you can waltz around the limit by using a dummy donor. You can give the money to someone (including the child) as a gift and have that person contribute.

Custodial accounts (often called UGMA or UTMA accounts) are another, more traditional form of college savings. With the latest tax cut kids can sell stocks in their accounts at a long-term gains rate of just 5%. But beware: Children gain legal control of the money at 18 to 21 (depending on state law) and can blow it on a Porsche instead of Princeton. Also, for children under 14, the “kiddie tax” hits investment earnings over $1,500 at the parents’ usually higher rate.

What about saving in your own name? That has some nontax advantages: more control over your investments; no penalty for spending on whatever you want; a chance to pick individual stocks; far less impact on potential financial aid. You can harvest any losses to offset taxable gains, and the top rate on long-term capital gains and on dividends is now just 15%. But then, this favorable rate expires, too, come 2009.